The Gallenstein Rule

 

It is a tax rule that will eventually go extinct.

It came to my attention recently that it can – however – still apply.

Let’s set it up.

(1)  You have a married couple.

(2)  The couple purchased real estate (say a residence) prior to 1977.

(3)  One spouse passes away.

(4)  The surviving spouse is now selling the residence.

Yeah, that 1977 date is going to eliminate most people.

We are talking Section 2040(b).

(b)  Certain joint interests of husband and wife.

(1)  Interests of spouse excluded from gross estate.

Notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest.

(2)  Qualified joint interest defined.

For purposes of paragraph (1), the term "qualified joint interest" means any interest in property held by the decedent and the decedent's spouse as-

(A)  tenants by the entirety, or

(B)  joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants.

In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr. G provided all the funds for the purchase. They owned the property as joint tenants with right of survivorship.

In 1987 Mr. G died.  

In 1988 Mrs. G sold 73 acres for $3.6 million. She calculated her basis in the land to be $103,000, meaning that she paid tax on gain of $3.5 million.

Someone pointed out to her that the $103,000 basis seemed low. There should have been a step-up in the land basis when her husband died. Since he owned one-half, one-half of the land should have received a step-up.

COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later.  Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.

Someone looked into Mrs. G’s situation and agreed. In May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8 million. Since the basis went up, the taxable gain went down. She was entitled to a refund.

Three months later she filed a second amended return showing basis in the land as $3.6 million. She wanted another refund.

This time she caught the attention of the IRS. They could understand the first amended but not the second. Where were these numbers parachuting from?

I am going to spare us both a technical walkthrough through the history of Code section 2040.

There was a time when joint owners had to track their separate contributions to the purchase of property, meaning that each owner would have his/her own basis. I suppose there are some tax metaphysics at play here, but the rule did not work well in real life. Sales transactions often occur decades after the purchase, and people do not magically know that they need to start precise accounting as soon as they buy property together. Realistically, these numbers sometimes cannot be recreated decades after the fact. In 1976 Congress changed the rule, saying: forget tracking for joint interests created after 1976. From now on the Code will assume that each tenant contributed one-half.

That is how we get to today’s rule that one-half of a couple’s property is included in the estate of the first-to-die. By being included in an estate, the property is entitled to a step-up in basis. The surviving spouse gets a step-up in the inherited half of the property. The surviving spouse also keeps his/her “old” basis in his/her original one-half. The surviving spouse’s total basis is therefore the sum of the “old” basis plus the step-up basis.

Mr. G died before 1977.

Meaning that Mrs. G was not subject to the new rule.

She was subject to the old rule. Since Mr. G had put up all the money, all the property (yes, 100%) was subject to a step-up in basis when Mr. G died.

That was the reason for the second amended return.

The Court agreed with Mrs. G.

It was a quirk in tax law.

The IRS initially disagreed with the decision, but it finally capitulated in 2001 after losing in court numerous times.

Mind you, the quirk still exists. However, the population it might affect is dwindling, as this law change was 47 years ago. We only live for so long.

However, if you come across someone who owned property with a spouse before 1977, you might have something.

BTW this tax treatment has come to be known by the widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein rule.”

A Puff Piece

 

Although we do not condone her inconsistency, we find it is merely puffery in an attempt to obtain new employment and of no significance here.”

There is a word one rarely sees in tax cases: puffery.

Puffery is an exaggeration. It approaches a lie but stops short, and presumably no “reasonable” person would believe what is being said or take it literally. The distinction matters if one’s puffery can be used against them as a statement of fact.

Let’s look at the Robinson case.

Mr Robinson had a lawn care business. Beverly Robinson had a job at Georgia Pacific, but in 2007 she started working at the lawn care business. She did the billing. She was also listed on the business checking account, but she never wrote checks.

She must have been the face of the business through, as for 2007 through 2009 most of the Forms 1099 to the business were sent in her name.

In 2010 the marriage went south. Mr Robinson moved out, and Beverly’s dad chipped-in to pay the mortgage on her house. Needless to say, she was not working at the company with all that going on.

In 2011 they filed a joint tax return for 2010. The return showed tax due of approximately $43 grand. She must have separated hard from the business, as no Forms 1099 were issued to her; all the Forms 1099 were issued to him.

COMMENT: I do not understand filing a joint tax return with someone you are likely to divorce. In Beverly’s defense, though, she did not realize that she had an option. They hired a tax preparer (likely because of the business), but the preparer never explained that the option to file separately existed.

In 2011 she was telling the IRS that they could not pay the 2010 tax debt. She also asked about innocent spouse status.

In 2012 they file a joint 2011 tax return. She was working again at another Georgia Pacific facility and had tax withholdings. The IRS took her withholdings and applied them to the 2010 tax year.

COMMENT: That is how it works.

In 2013 Beverly needed to find a new job. She uploaded her resume on a jobseeker website. She listed her Georgia Pacific gig. She also listed Robinson Lawn Care and embellished her duties, especially glossing over the fact that she no longer worked there.

In 2013 Mr Robinson somehow forced his way back into her house. She called the police and was told that they could not evict him since the two were still married.

In October, 2013 she filed a petition for dissolution of marriage.

About time. The year before Mr Robinson had fathered a child with another woman. In 2013 he started paying her child support.

The divorce became final in 2014. Mr Robinson agreed to assume the 2010 tax due.

Riiiight.

In 2015 she files for innocent spouse because of that 2010 tax debt and the IRS continuing to take her refunds.

The IRS turned down her request.

One of the requirements is that the tax liability for which the spouse is seeking relief belong to the “nonrequesting” spouse. In this case, the nonrequesting spouse was Mr Robinson.

He testified that he had moved out of the house in 2013. Oh, he also remembered Beverly working in the business in 2010.

Not good.

The IRS looked at certain Florida registrations that showed her name through 2014.

They also pointed out that she was a signatory on the business checking account.

Then they looked at her resume on that jobseeker website.

The Court was having none of it.

As for Mr Robinson:

Throughout the trial Mr. Robinson’s testimony was relatively inconsistent, and we give it little value.”

As for the registrations:

Although petitioner is listed as the registered owner of Robinson Lawn Care from December 1998 to December 2014, we find the reason for her filing the fictitious name--that her former husband worked during the day--is a sufficient explanation for why she is listed instead of Mr. Robinson. Moreover, she did not sign any State filings in 2010 or thereafter.

As for the checking account:

Similarly we find that petitioner’s name on the business account is not persuasive support for respondent’s position as Mr. Robinson had control of that account and she never wrote checks on it.

The Court pointed out that none of the 2010 Forms 1099 were made out to her, in clear contrast to prior tax years.

We saw above the Court’s comment on her puffery.

It was clear who the Court believed – and did not believe.

The Court decided that she was entitled to innocent spouse relief.

She cut it close, though.

Our case this time was Beverly Robinson v Commissioner of Internal Revenue T.C. Memo 2020-134.

Renting To Yourself And The "Cox" Strategy

My partner brought me a new client’s personal income tax return. He wanted me to “come up with tax ideas,” as though I am an Iron Chef deciding what to do with the show’s “secret” ingredient.

Something caught my eye. Let’s talk about it.

Let me set this up for you:

(1) Taxpayer is married.

(2) The wife is self-employed. More specifically, she is a proprietor and reports her business income on a Schedule C.

(3) The business owns a house used as offices. The business depreciates the house.

(4) As is true for Schedules C, all her profits are subject to self-employment taxes.

There you go. You have all the facts you need.

Got it yet?

It has to do with the house.

There is a tax case from the 1990s addressing self-rental between a business and its owner. Taxpayer (Cox) was an attorney who reported his practice as a sole proprietorship.  His offices were in a commercial building owned jointly by Cox and his wife. He paid himself rent of $18,000, which he deducted from the law practice and reported as rental income elsewhere on his return.

NOTE: Cox addressed the “passive activities” rules. He apparently had passive losses that he could release by generating passive income.  If so, his net rental income might zero-out, and he would still get an income tax deduction for paying himself rent. It would be a win-win – if only the self-rental rule did not prohibit it.

The IRS of course disallowed the $18,000 rent entirely.

Cox went to trial on a very interesting position. He and his wife owned the rental property as tenants by the entireties. He argued that the form of ownership made a tax difference.

The Tax Court was intrigued. It looked to Missouri property law, and it noticed two things. First, each spouse is entitled to the use and enjoyment of the entire property. Second, a spouse cannot unilaterally divest his spouse of his/her interest in the property.

In a tax venue, this meant that Mrs. Cox was entitled to half the rent, and that Mr. Cox could not divest her of that right.

And the Court allowed Mr. Cox a $9,000 deduction for rent on his Schedule C. It disallowed the other $9,000 (that is, his half) under the self-rental rule.

How does this apply to the new client?

Taxpayer and her husband own the house. She owns the business. I see a strategy… for her self-employment tax.

Did I trip you up?

Remember: all her Schedule C income is subject to self-employment tax, which currently is 15.3 percent. One way to reduce it is to take a tax deduction on her Schedule C and report the corresponding “income” somewhere else on her tax return - somewhere that is NOT subject to self-employment tax. Somewhere like a real estate rental.

The tax pros refer to this a “Cox” strategy. The strategy we are talking about may also cause additional taxes under the new Obamacare “net investment income” tax. A tax advisor would have to review the situation and run numbers.

Still, it is something, and it is all your money until they take it from you. If this applies to your business situation, please bring it to your tax advisor’s attention. 

Change In Innocent Spouse Tax Relief

You may have read or seen that the IRS has ‘changed” the rules for innocent spouse relief. 

While this is not wrong, it is incomplete. How? Because there are three ways to request innocent spouse status, and the IRS has changed one of them. The other two remain as they were before.

Being married and filing a joint tax return with your spouse is what creates this issue. You later divorce or separate from your spouse. You and your (now ex) spouse are audited by the IRS. Remember, the IRS lags a year or two before they select returns for audit. The IRS finds unreported income and assesses additional tax.  The income triggering the tax belongs to your ex-spouse.

Let’s return to the joint tax return you filed. A joint return means that you are “jointly and severally liable.”  The IRS can proceed against you alone, against your spouse alone or against the two of you.  The IRS can, and likely will, proceed against you (for at least 50%) even if it wasn’t your fault. From their perspective, why not? They have nothing to lose, and it doubles their chance of getting someone to pay.

This is the point of innocent spouse relief. You want to separate your tax from that of your ex-spouse. Ideally, you want to completely separate your tax, so that the IRS leaves you alone for any additional tax, penalties and interest.

There are three types of innocent spouse relief.

Type I is “general” relief:

(1)   You filed a joint return.

(2)   The return has an “understatement of tax” due to “erroneous” items of your spouse (or ex-spouse).

(3)   You can show that at the time you signed the joint return you did not know, and had no reason to know, that there was an understatement of tax.

(4)   Considering all the “facts and circumstances,” it would be unfair to hold you liable for the understatement of tax.

An “erroneous” item is IRS-speak for not reporting income or for overstating deductions.

The third requirement can be a tough to meet.  It is possible that you did not know, but that is not enough. The IRS wants to be sure that you had no reason to know. For example, you and your spouse reported $60,000 of income. That year you and your spouse bought a Colorado chalet and a Bugatti Veyron. Unless you had savings to tap into or one of you inherited, expect the IRS to be very skeptical of you denying any “knowledge.” They will figure that you should have known.  And it doesn’t have to be as dramatic as a Swiss chalet. Perhaps you and your ex moved to a nicer neighborhood. Or enrolled the kids in a private school. Or started showing horses.  A quick review of your income and savings would prompt one to wonder how you paid for everything. Expect the IRS to argue that you had “constructive” knowledge. That is, you “had reason to know.”

Type II is “separation of liability.”

Under this method, you separate your income and deductions from your (ex) spouse’s income and deductions. You then calculate your separate tax on such separate income. You are trying to get the IRS to agree that your share of the joint tax is that amount and not more.

It does have the advantage of appearing “fair.”

Oh, the IRS requires that you be divorced, legally separated or at least living apart for the 12-month period preceding the innocent spouse filing. Don’t be surprised if your tax planning includes advice to get divorced.

What is going to sour the IRS on this deal, other than their general reluctance to let anyone off the hook?  Well, that “knowledge” requirement we discussed previously will derail you, with one important distinction: you must have actually known of the tax understatement. The “you should have known” argument is not good enough to deny you the second type of innocent spouse relief.

A second thing that will sink the separation of liabilities is transferring assets for the main purpose of avoiding payment of tax. You can expect the IRS to want to review every significant asset move between you and your ex.

You must request Type I and Type II innocent spouse relief within 2 years after the date on which the IRS first begins collection activity against you. This is not the same as the date you filed the return. Rather it is the date that the IRS sends you a letter or asks you to go downtown for a meeting.

Type III is “equitable relief.”

Equitable relief is only available if you meet the following conditions:

• You do not qualify for innocent spouse relief or separation of liability.
• The IRS determines that it is unfair to hold you liable for the understatement of tax taking into account all the facts and circumstances.

Well, unfair is in the eye of the beholder, isn’t it? What facts and circumstances will the IRS consider as they ponder whether to be fair or unfair?

·        

• Current marital status
• Abuse
• Reasonable belief of the spouse requesting innocent spouse, at the time he or she signed the return, that the tax was going to be paid; or in the case of an understatement, whether that  spouse had knowledge or reason to know of the understatement
• Current financial hardship or inability to pay basic living expenses
• Legal obligation to pay the tax liability pursuant to a divorce decree or other agreement to pay the liability
• To whom the liability is attributable
• Significant benefit received by the spouse asking for innocent spouse
• Mental or physical health of the spouse requesting innocent spouse on the date that spouse signed the return or requested relief
• Compliance with income tax laws following the taxable year or years to which the request for relief relates

The IRS had previously held Type III relief to the same time limit as Types I and II. While not in the Code itself, the IRS inserted the time limit into its Regulations and battled hard to have the courts accept its position.

The IRS lost a high profile case (Lantz) on this issue in 2010. Lantz was the former wife of an Indiana dentist. In 2000 her then-husband was arrested for Medicaid fraud. Shortly thereafter came a $900,000 IRS bill. She didn’t file for innocent spouse because he told her that he had taken care of it. He did not, of course. Shortly thereafter he died.

And of course more than two years had gone by…

Mrs. Lantz filed for Type III innocent spouse. In 2009 the Tax Court sided with her. In 2010, however, the Appeals Court sided with the IRS.

The IRS Taxpayer Advocate howled at what was happening to Mrs. Lantz. Forty-nine members of the House of Representatives sent a letter to the IRS Commissioner demanding a stop to such behavior.  

The IRS did, and in 2011 it announced that it was backing-off the two-year requirement for Type III innocent spouse claims. 

The IRS has now published Regulations formalizing what it announced back in 2011.   

So how long do you have now to file a Type III innocent spouse claim? You have ten years – the same period as the IRS has to collect taxes from you.

Note though that Type I and Type II still have the two-year requirement. It is only Type III that has changed. Why the difference? Because for Types I and II, the two-year requirement is written into the law.

My Thoughts: To hold an innocent spouse to a two-year window – when the law passed by Congress said nothing about a two-year window for Type III relief – was a clubfooted mistake by the IRS. It is a bit late, but the IRS finally got it right.

By the way, if you have been turned down for innocent spouse – and you are still within the ten-year window – please consider filing again under the new rules.

Couples Must Now File Separate Powers of Attorney

Starting March 1, 2012 married couples will have to file separate powers of attorney for their tax representative.

It used to be that both spouses could sign one power naming a representative. You may recall that you signed near the top of page 2. That has changed because of increased sensitivity to privacy and data security.

There is another change on the power, but the change applies to tax representatives. The representative must now include his/her PTIN on the power. Tax advisors may remember that the IRS has discussed increased practitioner enforcement, including automatic referral to the Office of Professional Responsibility of a practitioner associated with a substantial understatement penalty. The PTIN is a way to identify a specific return to a specific tax preparer.